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Dividend strategy gut check

SCOTT KEFER, CFA 23-Sep-2019

Investors sometimes need a bit of intestinal fortitude. That has been the case throughout much of 2019 thanks to periodic bouts of significant volatility. 

In this environment it’s no surprise why some investors may wish to embrace dividend-paying strategies. Dividend payers are beloved for their “yield support,” which comes in the form of regular payments to shareholders that can be potentially comforting during steep drawdowns.

Collecting regular dividends (or reinvesting them) is one thing. But I believe that those companies with accelerating dividend growth are a cut above and may be an excellent harbinger of long-term company health. 



But don’t take my word for it. Check out the evidence, which shows companies with a consistent history of rising dividends have not only generated superior returns over the long term, but they have done so with less risk (as measured by standard deviation*), compared to stocks that pay no dividends at all or even those that simply keep dividends unchanged.   

When you step back to think about it, the relative outperformance of companies with accelerating dividends should not be a surprise. Dividend growers often exhibit strong fundamentals, evidenced by their stable earnings streams and history of profit growth. Moreover, any company that has demonstrated the ability to raise dividends consistently is likely run by astute management that allocates capital judiciously. And the simple fact that they pay out increasing amounts of capital illustrates their commitment to shareholder returns. These are the types of companies that investors may wish to favor during times of uncertainty. 

Importantly, not all dividend-focused strategies are built the same. Many of the popular approaches are backward-looking and focus exclusively on a company’s dividend history. Some require as much as 25 years of dividend growth for inclusion. There’s certainly nothing wrong with a company that has a long track record of paying dividends. I may want to own some of them too. But relying on dividend history alone is likely to result in tilting a portfolio toward mature, larger companies that may be past their prime growth years (often at the exclusion of younger, faster-growing firms). This might also exclude companies like Home Depot, Visa and Disney that have less than 10 years of dividend history but still might be worthy of inclusion in a dividend strategy. And then there is also the potential for possible sector concentration, to say nothing of the need to understand dividend policy and the nuances of each company’s dividend history.

History is important, but fundamentals still matter when it comes to dividend investing. To maximize the potential benefits of a dividend strategy, I believe an approach that uses dividend history in conjunction with some fundamental screening is the best way to find quality, profitable companies with the highest probability of future dividend growth. This type of fundamental, forward-looking focus can also help identify dynamic companies that have a long runway for potential growth—and accelerating dividends. 

*Standard Deviation: A statistical measure of volatility indicating the risk associated with a return series. Standard deviation of return measures the average deviations of a return series from its mean and is often used as a measure of risk. A large standard deviation implies that there have been large swings in the return series of the manager.

**Sharpe Ratio: A portfolio’s excess return over the risk-free rate divided by the portfolio’s standard deviation. The portfolio’s excess return is its geometric mean return minus the geometric mean return of the risk-free instrument (by default, T-bills).